CFA Level 2 Economics

kishoreagarwal
Posts: 1
Joined: Sat Mar 01, 2014 4:28 pm

CFA Level 2 Economics

Postby kishoreagarwal » Sat Mar 01, 2014 4:43 pm

The doubt is of economics regarding Interest rate parity(IRP).
1) why does IRP does not hold in short run?
2) why does uncovered IRP assumes that the investor is risk neutral?
3) In case of covered IRP , why does bank quote different forward rate , so that there is arbitrage ? bank can quote the rate where there is no arbitrage ? why does it happens and how relevant is IRP in real world?

pradeeppdy
Finance Junkie
Posts: 258
Joined: Thu Sep 20, 2012 3:42 pm

CFA Level 2 Economics

Postby pradeeppdy » Wed Apr 02, 2014 4:42 am

Interest rate parity is an non-arbitrage condition which says that the returns from borrowing in one currency, exchanging that currency for another currency and investing in interest-bearing instruments of the second currency, while simultaneously purchasing futures contracts to convert the currency back at the end of the investment period, should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency

IRP holds better under rational expectations of agents, and PPP assumptions does not allow even temporary volatility/deviations from price level equilibriums (and also it explains only long-run but doesn't fits short-run).

pradeeppdy
Finance Junkie
Posts: 258
Joined: Thu Sep 20, 2012 3:42 pm

CFA Level 2 Economics

Postby pradeeppdy » Wed Apr 02, 2014 4:55 am

When the no-arbitrage condition is satisfied without the use of a forward contract to hedge against exposure to exchange rate risk, interest rate parity is said to be uncovered. Risk-neutral investors will be indifferent among the available interest rates in two countries because the exchange rate between those countries is expected to adjust such that the dollar return on dollar deposits is equal to the dollar return on foreign deposits,

pradeeppdy
Finance Junkie
Posts: 258
Joined: Thu Sep 20, 2012 3:42 pm

CFA Level 2 Economics

Postby pradeeppdy » Wed Apr 02, 2014 5:36 am

Forward rates are decided by market conditions. The demand and supply conditions of forward rates at various maturity decide upon the rates the banks quote .For eg at 6 months maturity the forward quotes may be different than 1 yr. maturity . The demand of foreign currency by market participants and supply for this fix the forward rate . Bank itself cannot decide the rate. IRP holds good in long run.


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